Chapter 7 Producers in the Short Run

Transcription

1 Chapter 7 Producers in the Short Run 7.1 What are Firms? Organisation of Firms 1) Single proprietorship Has one owner who is personally responsible for the firm s actions and debts 2) Ordinary partnership Has two or more joint owners, each of whom is personally responsible for the firm s actions and debts 3) Limited partnership Has two classes of owners: General partners Take part in managing the firm Are personally liable for the firm s actions and debts Limited partners Take no part in the management of the firm Risk only the money that they have invested 4) Corporation Has a legal eistence separate from that of the owners Owners not personally responsible Private Shares not traded on any stock echange Public Shares traded on stock echanges 5) State-owned enterprise Owned by the government Under the direction of a more or less independent state-appointed board Organisation and legal status similar to corporation 6) Non-profit organisations Provide goods and services with the objective of just covering their costs Earn their revenues from sales and donations Multinational Enterprises (MNEs) Firms that have operations in more than one country Their growing number reveals an increasing role for these corporations in the ongoing process of globalisation Not all production in the economy takes place within firms. Many government agencies provide goods and services (financed by ta revenues)

2 Financing of Firms Financial capital: Real capital: the money a firm raises for carrying on its business basic types: equity & debt the firm s physical assets (factories, machinery, offices, finished goods) EQUITY Individual proprietorships & partnerships One or more owners provide much of the required funds Corporations Acquire funds from its owners in return for stocks, shares, or equities Dividends Profits that are paid out to shareholders Retained Earnings Retaining current profits rather than paying them out to shareholders Way for an established for to raise money Add value to the firm, raise market value of eisting shares DEBT Debt instruments Loan agreements Characteristics They carry an obligation to: repay the amount borrowed (aka, the principal of the loan) make some form of payment to the lender (aka, interest) Bonds A debt instrument carrying a specified amount, a schedule of interest payments, and (usually) a date of redemption of its face value Redemption date: the time at which the principal is to be repaid Term: the amount of time between the issue of the debt and its redemption date Goals of Firms The desire to maimise profits is assumed to motivate all decisions made within a firm, and such decisions are assumed to be unaffected by the peculiarities of the persons making the decisions and by the organisational structure in which they work Assumptions 1) Firms are profit-maimisers 2) Each firm is a single, consistent decision-making unit Allow the theory to ignore the firm s internal organisation and its financial structure economists to predict behaviour of firms

3 the firm will select an alternative that produces the largest profits Social responsibility a) Every firm has a responsibility to society that goes beyond the responsibility to its shareholders; VS b) By maimising profits, firms are providing a valuable service to society 7.2 Production, Costs, and Profits Production INPUTS Intermediate products All outputs that are used as inputs by other producers in a further stage of production Inputs that are provided directly by nature (Land) Inputs that are provided directly by people (Labour) Inputs that are provided by the factories and machines (Capital) PRODUCTION FUNCTION Functional relation showing the maimum output that can be produced by any given combination of inputs Q = f (L, K) Q: flow of output K: flow of capital services L: flow of labour services f: production function itself Changes in the firm s technology, which alter the relationship between inputs and output, are reflected by changes in the function f. Costs and Profits Firms arrive at profits by taking the revenues they obtain from selling their output by subtracting all the costs associated with their inputs. ECONOMIC VERSUS ACCOUNTING PROFITS Accounting profits = Revenues Eplicit costs Eplicit costs: costs that actually involve a purchase of goods or services by the firm E.g.: hiring of workers, renting equipment, interest payments on debt, purchase of intermediate inputs

4 Economic Profits = Revenues (Eplicit costs + Implicit costs) = Accounting profits Implicit costs The difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output. Implicit costs: items for which there is no market transaction but for which there is still an opportunity cost for the firm Opportunity cost of the owner s TIME (over and above his salary) In small and new firms, where owners spend a lot of time developing the business They often pay themselves far less than they could earn elsewhere E.g.: entrepreneur who pays herself $1,000/month instead of the $4,000/month from the best alternative job. Implicit cost = $3,000 Eplicit cost = $1,000 Opportunity cost of the owner s CAPITAL (including a possible risk premium) Applies to small business and to large corporations Two questions to ask a) What could be earned by lending this amount to someone else in a riskless loan E.g.: government bond with 6% return b) What could the firm earn in addition to this amount by lending its money to another firm where the risk of default is equal to the firm s own risk of loss? E.g.: risk premium of 4% If the firm does not epect to earn this much in its own operations, it could close down and lend its money out to some equally risky firm and earn 10% Negative economic profits are called economic losses PROFITS AND RESOURCE ALLOCATION Economic profits and losses play a crucial signalling role in the workings of a free-market system Economic profits in an industry are the signal that resources can profitably be moved into that industry When the revenues of all the firms in some industry eceed opportunity cost, the firms in that industry will be earning pure economic profits. The owners will therefore want to move resources into the industry, because the earnings potentially available to them are greater there than in alternative uses. Losses are the signal that the resources can profitably be moved elsewhere. Only if there are zero economic profits is there no incentive for resources to move into or out of an industry

5 Profit-Maimising Output π = TR TC π: the level of output that will maimise a firm s profit TR: Total Revenue TC: Total Cost What happens to profits as output varies depends on what happens to both revenues and cost Time Horizons for Decision Making THE SHORT RUN Period of time in which the quantity of some inputs (fied factors) cannot be increased beyond the fied amount that is available The length of time over which some of the firm s factors of production are fied Fied factor an input whose quantity CANNOT be changed in the short run usually an element of capital (e.g.: plant, equipment) might be land, the services of management, supply of skilled labour Variable factor an input whose quantity CAN be changed over the time period under consideration THE LONG RUN Period of time in which all inputs may be varied, but the eisting technology of production cannot be changed The length of time over which all of the firm s factors of production can be varied, but its technology is fied Corresponds to the situation the firm faces when it is planning to go into business, to epand, to branch out, or to change its method of productions THE VERY LONG RUN Period of time that is long enough for the technological possibilities available to a firm to change The length of time over which all of the firm s factors of production and its technology can be varied

6 7.3 Production in the Short Run As the quantity of labour varies, with capital being fied, output changes Fied factors: machinery & equipment Variable factors: intermediate inputs & labour services Total, Average, and Marginal Products (Fig. 7-1) TOTAL PRODUCT (TP) Total amount produced by a firm during some period of time AVERAGE PRODUCT (AP) Total product divided by the number of units of the variable factor used in its production AP = TP/L L: number of units of labour Point of diminishing average productivity: the level of labour input at which AP reaches a maimum Up to that point, AP is increasing Beyond that point, AP is decreasing MARGINAL PRODUCT (MP) The change in total output that results from using one more unit of a variable factor MP = ΔTP/ΔL MP first rises and then falls as output increases Point of diminishing marginal productivity: the level of labour input at which MP reaches a maimum Diminishing Marginal Product Law of Diminishing Returns The hypothesis that if increasing quantities of a variable factor are applied to a given quantity of fied factors, the marginal product of the variable will eventually decrease In order to increase output in the short run, more and more of the variable factor is combined with a given amount of the fied factor As a result, each unit of the variable factor has less and less of the fied factor with which to work Sooner or later, equal increases in labour eventually begin to add less and less to total output When the decline takes place, each additional worker will increase total output by less than did the previous worker

7 The Average-Marginal Relationship If increasing quantities of a variable factor are applied to a given quantity of fied factors, the average product of the variable factor will eventually decrease The AP curve slopes upward as long as the MP curve is above it Whether the MP curve is itself sloping upward or downward is irrelevant In order for the AP to rise, the MP must eceed the average product If the marginal is greater than the average, the average must be rising If the marginal is less than average, the average must be falling 7.4 Costs in the Short Run Short-Run Costs TOTAL COST (TC) The sum of all costs that the firm incurs to produce a given level of output Can be divided into Total Fied Cost and Total Variable Cost TC = TFC + TVC TOTAL FIXED COST (TFC) All costs of production that do not vary with the level of output The cost of fied factors aka overhead cost e.g.: Rent TOTAL VARIABLE COST (TVC) Total costs of production that vary directly with the level of output Rises when output rises Falls when output falls The cost of variable factors E.g.: Labour, intermediate inputs AVERAGE TOTAL COST (ATC) Total cost of producing any given number of units of output divided by that number of units of output Can be calculated as the sum of AFC and AVC ATC = TC/Q ATC = AFC + AVC Q: total units of output

8 AVERAGE FIXED COST (AFC) Total fied cost divided by the number of units of output Declines continually as output increases because the amount of the fied cost attributed to each unit of output falls AFC = TFC/Q aka: spreading overhead AVERAGE VARIABLE COST (AVC) Total variable cost divided by the number of units of output AVC = TVC/Q 1) First declines as output rises, 2) Reaches a minimum, 3) Then increases as output continues to rise MARGINAL COST (MC) Increase in total cost resulting from increasing output by one unit Is always marginal variable cost because fied costs do not change as output varies Calculated as the change in total cost divided by the change in output that brought it about: MC = ΔTC/ΔQ Short-Run Cost Curves (Fig. 7-2) MC curve cuts the ATC and AVC curves at their lowest points ATC curve slopes downward whenever the MC curve is below it It slopes upward whenever the MC cure is above it THE AFC, AVC, AND ATC CURVES Spreading Overhead AFC Curve steadily declines as output rises Since there is a given amount of capital with a total fied cost, increases in the level of output lead to a steadily declining fied cost per unit of output (Not u-shaped) AVC Curve declines as output rises, reaching a minimum As output increases above this level, AVC rises U-shaped ATC Curve is the sum of AFC and AVC Derived from vertically adding the AFC and AVC curves ATC curve initially declines as output increases, reaches a minimum, and then rises as output increases further (U-shaped) THE MC CURVE The points on the curve are plotted at the midpoint of the output interval Declines steadily as output initially increases, reaches a minimum, and then rises as output increases further (U-shaped)

9 WHY U-SHAPED COST CURVES? Since labour adds directly to cost, the relationship between labour input and output the AP and MP curves is closely linked to the relationship between output and cost the AVC and MC curves. Relationship between AP and AVC Curves AP curve shows that as the amount of labour input increases, the average product of labour rises, reaches a maimum, and then eventually falls But each unit of labour adds the same amount to total variable cost (TVC) Thus, each additional worker adds the same amount to cost but a different amount to output When output per worker (AP) is rising, the variable cost per unit of output (AVC) is falling When output per worker (AP) is falling, AVC is rising AVC is at its minimum when AP reaches its maimum Eventually diminishing average product of the variable factor implies eventually increasing average variable cost Relationship between MP and MC curves Since each unit of labour adds the same amount to cost but has a different marginal product: When MP is rising, MC is falling When MP is falling, MC is rising MC curve reaches its minimum when the MP curve reaches its maimum Eventually diminishing marginal product of the variable factor implies eventually increasing marginal costs Since ATC = AFC + AVC The ATC curve gets its shape from both the AFC and the AVC curves The AFC curve is steadily declining as a given amount of overhead is spread over an increasing number of units of output AVC curve is u-shaped because of AP/AVC relationship ATC curve begins to rise (after reaching its minimum) only when the effect of the increasing AVC dominates the effect of the declining AFC ATC curve reaches its minimum at a level of output above where AVC reaches its minimum EXTENSIONS IN THEORY What the flat cost curves eplain well is the observed fact that firms costs do not always rise and fall precisely as output rises and falls in response to season and cyclical variations in demand Capacity The level of output that corresponds to the minimum short-run average total cost The largest output that can be produced without encountering rising average costs per unit Ecess capacity: A firm producing at an output less than the point of minimum ATC

10 Shifts in Short-Run Cost Curves SR curves are drawn holding two things constant: 1) The amount of the fied factor used by the firm 2) Factor prices The price per unit of labour The price per unit of capital CHANGES IN FACTOR PRICES (Fig. 7-3) Increase in the wage: Increases variable costs Fied costs unaffected Increases firm s total costs Increase the firm s marginal costs Upward shift in the firm s ATC and MC curves Increase in the price of a unit of the fied factor: Firm s total fied cost will rise Variable costs unaffected Upward shift of ATC, MC curve unaffected CHANGES IN THE AMOUNT OF THE FIXED FACTOR In the short-run: fied factor = physical capita Increase in the size of firm s factory: Long-run decision by the firm Once the larger factory is in place, the firm s total fied costs have increased The increase in the size of the factory means that labour and other variable factors now have more physical capital with which to work Increases their average costs at any given level of output Overall effect on ATC is difficult to predict without having more information about the firm s technology We need to have more detailed information about the firm s production function before we know how a change in the firm s plant size will affect its ATC curve.